MTRN - Materion Surges On Optimism For 2023 And Beyond

Summary

• Materion delivered positive operating leverage in Q4 and solid initial guidance for 2023, but the share price reaction seems excessive.
• Semiconductor and consumer electronics markets will be more challenging in 2023, but aerospace and energy remain strong.
• It will take a little time, but Materion's investments in advanced materials for batteries, connectors, motors, optics, and sensors will pay off as automation, clean energy, and electrification accelerate.
• Materion's share price already prices in a lot of growth and margin leverage, but it's a name to watch for a pullback.

These are good days to be a specialty materials company. I've written positively about specialty alloy companies ATI ( ATI ) and Carpenter ( CRS ), and both have done well over the past year. Materion ( MTRN ) is a different sort of business, one that involves greater technical and material science knowhow, but the company has nevertheless done well on strength in end-markets like semiconductors, aerospace, and energy, and the prospects for advanced material demand in a range of markets related to aerospace, communications, electrification, and energy (clean and conventional) are very strong.

Materion shares rocketed higher after fourth quarter earnings and it's once again a tough valuation call to make. I like the growing end-markets that Materion serves, particularly areas like advanced semiconductor packaging, clean energy, and electrification, and I certainly recognize the value of the company's capabilities - as do its commercial partners, which have in some cases been willing to shoulder some of the cost of the capacity investments needed to produce the components they need. If you prize story over valuation, these shares may still work for you, but I have more challenging time on the valuation side.

Ending The Year With Some Momentum

Despite the share price reaction, Materion's fourth quarter results were not that far out of line with expectations. Revenue was actually a little light (but more solid on a value-added basis), though margins were good.

Revenue rose 9% as reported, but 26% in organic value-added terms, and I believe value-added revenue is the right way to look at this company's financials (it better reflects what customers are willing to pay for Materion's capabilities). The Performance Materials business grew 53%, helped by an acquisition and strength in end-markets like aerospace, industrial, energy and data/telecom, while Electronic Materials grew 16% on stronger energy market demand. Precision Optics declined 15%, undermined by consumer electronics weakness and discontinued products/business lines.

Gross margin improved one point year over year and 330bp qoq to 31.8% on a value-added basis, with Performance Materials driving the strength (32.5%); though Electronic Materials did improve more than two points sequentially. EBITDA rose 40% year over year, with margin up 120bp to 18%.

Operating income rose 153% from the year-ago level, with strong improvement at Performance Materials (up 132%) and Electronic Materials (up 40%), offset by weakness at Precision Optics (down 70%). Overall value-added operating margin improved 620bp yoy and 270bp sequentially to 12.7%, with margin in Performance Materials jumping to 21.2% (from 14%) and Electronic Materials improving to 11.8% (from 9.8%).

Mid-Single-Digit Core Revenue Growth Looks Attainable

Materion is going to see a lot of end-market cross-currents in 2023, even though I believe core demand and potential share of wallet/bill of materials continues to improve.

The semiconductor market was up 2% this quarter in organic terms, which is still better than underlying industry wafer starts (down about 2%). The next couple of quarters are still looking soft for overall industry volumes, but should recover in the second half of 2023. Beyond this short-term cyclical correction I continue to expect mid-single-digit volume growth across the long term, with volume growth driven by increased content in autos and industrial equipment, as well as ongoing growth in data/telecom, sensing, and so on.

Consumer electronics is in a similar position, albeit with weaker end-market fundamentals right now. PC demand declined sharply in the fourth quarter and global smartphone demand has likewise been quite weak. These markets should be close to bottoming, though, and a return to modest growth in the second half (against easier comps) seems plausible.

Other markets are considerably stronger. Energy (up 49% in the fourth quarter) continues to offer Materion good opportunities in both fossil fuel (alloys that can resist harsh conditions in oil/gas exploration and production) and renewable energy (materials used in panels, inverters, turbines, batteries, and so on). Aerospace also continues to enjoy a strong rebound, with Materion's materials well-positioned for growth in connectors and bushings/bearings, as well as emerging opportunities in space (optics and components for electrical and propulsion systems).

One market that confounds me a bit is autos. Materion is well-leveraged to the growth in electrified vehicles through battery technology/materials, connectors, and alloys and components used in motors, but revenue was down 11% this quarter as weaker legacy product sales overwhelmed EV-driven growth. This will still be a headwind in 2023 (management is looking for low single-digit growth), but as the company scales up its production capabilities and as BEV production rates increase, I expect Materion to see strong tailwinds from BEV opportunities.

The Outlook

It may be overly simplistic, but one of the strongest endorsements for the value that Materion brings is the fact that on multiple occasions customers have chosen to advance funding for capex projects that Materion needs to produce the alloys, composites, and components that they want. When your customers are willing to help fund the capex you need to produce the products they want to purchase from you, that's a good sign.

That said, while the shares spiked on fourth quarter earnings and 2023 guidance, I don't see a big change to my outlook. Management's market-by-market growth projections support my prior outlook for mid-single-digit growth, and while I've raised my margin assumptions (by about 80bp for EBITDA in 2023), they're not transformative changes. Likewise with free cash flow - management did a little better than I'd expected this year, but I'm still looking for high single-digit long-term FCF margins that drive high-teens growth like I was before.

This isn't to say that I don't see improvements at the business. It's going to take time, but I like the company's leverage to aerospace (including defense and space), electrification (vehicles, commercial buildings, and factory floors), and energy. Ventures like a new advanced chemicals facility for semiconductor and battery/EV materials will help support revenue acceleration down the line, as will investments in sensor and connector/interconnect materials - all of which are likely underestimated components as automation and electrification accelerate across multiple end-markets.

The Bottom Line

At this point I can get a fair value of around $110, which isn't that exactly next to today's share price. I freely admit I may be behind the curve as far as revenue growth and margin upgrades, but I don't think there's a big transformation coming over the next 12 to 18 months and I've long been positive on the longer-term growth opportunities here. Should these shares cool off a bit, I'd certainly take a look, but I wouldn't be eager to chase at this point.

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